Small business Law Articles

Employee Liability For Corporation's Obligations

In many cases, shareholders and directors of a small business can have liability for the bad actions of a corporation. Usually this liability comes from arguments to disregard the corporate form or to "pierce the corporate veil." This Colorado case finds that an employee that is heavily involved in running the business can also have personal liability for the obligations of a small business.

byon Dec 1, 2009

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In many cases, shareholders and directors of a small business can have liability for the bad actions of a corporation. Usually this liability comes from arguments to disregard the corporate form or to "pierce the corporate veil." This Colorado case finds that an employee that is heavily involved in running the business can also have personal liability for the obligations of a small business.

Marc Winger managed the business of Manitoba Investment Advisors, Inc. He was not a shareholder, officer or director of Manitoba. A landlord sought to hold Mr. WInger liable for obligations under a lease of Manitoba, which became insolvent and dissolved before paying its lease obligation.

Important Tip Small businesses must operate corporations and other limited liability entities properly or courts may find the owners, officers, directors or, in some cases, employees liable for the obligations of the company.

Usually, shareholders, directors, officers and other insiders are not responsbile for the debts or other obligations of a corporation. In some cases where the form of the corporation is not maintained, a court may find shareholders, directors, officers or other insiders responsible.

Colorado uses a three-part test for determining when to disregard a corporation or other limited liability company.

First, a court must determine whether the corporate entity is the "alter ego" of the person. Courts consider eight factors in determining whether the corporate entity is an alter ego:

the corporation is operated as a distinct business entity

funds and assets are commingled

adequate corporate records are maintained

the nature and form of the entity's ownership and control faciliatate misuse by an insider

the business is thinly capitalized

the corporation is used as a "mere shell"

legal formalities are disregarded

corporate funds or assets are used for noncorporate purposes

Second, a court must determine whether justice requires recognizing the substance of the relationship between the person or entity sought to be held liable and the corporation over the form because the corporate form was "used to perpetrate a fraud or defeat a rightful claim."

Third, a court must determine whether an equitable result will be achieved by disregarding the corporate form and holding a shareholder or other insider personally liable for the acts of the business entity.

All three prongs must be satisfied.

Finally, in this case, the court determined that in Colorado, non-shareholder insiders can be liable when they have dominance and control over the corporation and use the corporate entity as a mere instrumentality for the transaction of the insider's own affairs. Other states have made similar holdings. Mr. Winger exercised control and dominance over Manitoba.

In this case, Manitoba was found to lack economic substance and to be a mere shell. The nature and form of ownership and control faciliated Mr. Winger's misuse. It was not operated as a distinct business entity. Therefore, the court found that Mr. Winger was the alter ego of Manitoba and the first test was met for piercing the corporate veil.

The second test was also met in this case. Although there was no indication of fraud, Mr. Winger used the corporate form to defeat the "rightful claims" of the landlord. The corporate form was abused in such a manner as to defeat the rightful claim of the landlord in that Mr. WInger removed all available corporate funds from Manitoba thus leaving no funds to satisfy its obligations.

The court did not address the third test under Colorado law (it sent it down to the lower court to make the decision as to the thrid test). It is hard to imagine that the third test will not also be met in this case. Given the abuse of the corporation and the defeat of the "rightful claims" of the landlord, the lower court will likely use its equitable discretion to pierce the veil. Indeed, this court may have practically reduced the three-part test in Colorado to a one-part test - if you abuse the corporate form by one or more of the eight factors above, you will likelt be liable to any creditors affected by that abuse.

In light of this reduction of the protections of a limited liability company, it is advisable for small businesses to pay even greater attention to the corporate form and make sure there are proper legal controls in place.

Additional Information

Important Tip:

Small businesses must operate corporations and other limited liability entities properly or courts may find the owners, officers, directors or, in some cases, employees liable for the obligations of the company.